Journal of RegulatoryEconomics;7:43~52 (1995) 9 KluwerAcademicPublishers Impact of Regulation on Demand Side 1 Conservation Programs FRANZ WIRL Technical University of Vienna, Austria Institute of Energy Economics, Guflhausstr. 27-29, A-1040 Wien, AUSTRIA Abstract This paper reviews critically the economics of utility demand-side conservation programs under different regulatory regimes introducing a service-oriented framework in order to derive simultaneously the demand for electricity and for efficiency. This framework establishes a relation between engineering efficiency improvements, the rebound effect (i.e., more efficient appliances tend to increase the service demand), and actual conservation. Price-cap regulation, which is consistent with least cost planning (LCP), leads to the necessary condition for (profitable) DSM that the price cap does not cover the marginal costs of supplying electricity. The difference between the marginal costs and the price cap determines the upper bound on the costs of a "negawatt." This necessary condition for LCP cannot be met within the traditional model of rate-of-return regulation so that other incentives ("shared saving") induce the utility to undertake DSM. A profit-maximizing, regulated utility subverts the DSM expenditures to inflate the rate base yet minimizing the impact on revenues. Therefore, a rate-of-return regulated utility might favor "inefficient" conservation programs, which helps to explain that the costs of actual conservation exceed the a priori expectations by far. Finally, DSM as a permanent option will increase free riding substantially, due to strategic consumer reactions. 1. Introduction The efficiency of demand side management programs (abbreviated DSM in the following) is one of the most topical and heavily debated issues in applied utility regulation. The ongoing and voluminous academic discussions have a strong impact on the public debate (see e.g., Time, January 2, 1989; Newsweek, June 18, 1990; and The Economist, March 16th 1991) and on the regulatory practice such that by 1992 approximately 2 billion U.S. $ were spent by utilities on DSM according to Gilbert-Stoft (1992). The Public Utility Regulatory Policy Act of 1978 (PURPA) provided the political and legal framework to set energy conservation as a national and regulatory goal and thereby encouraged regulatory commissions to initiate utility conservation programs; see Nowell-Tschirhart (1990). Although the aim of DSM is twofold (load management and conservation), this paper, like many others (and the public debate too) concentrates on conservation. The documentation of DSM undertaken by United I acknowledgediscussions with ReinhardHaas and suggestionsfromthe editorof the joumal, Professor Michael A. Crew. I am particularlygrateful for the extensive,constructiveand, in the end, very helpful comments from an anonymousreferee.